Regulating the Financial Analysis Industry: Is the European Directive Effective?

Abstract

This study examines the economic consequences of the Market Abuse Directive which is notably aimed at curbing conflicts of interest in the EU. It focuses on the impact of this new regulation on stock price changes associated with recommendations issued by analysts potentially affected by conflicts of interest because they work for a financial institution having strong business ties with the firms they recommend. The empirical evidence indicates that only 2% of the recommendations under study were potentially biased by conflicts, versus 60% in the US. Furthermore, following MAD adoption, the proportion of Buy recommendations dropped only by 4.5% (versus 14% in the US following SOX501) and the proportion of Sell recommendations increased by 2% (versus 7.6% in the US). Regarding stock price effects, we find that MAD had a positive and significant impact on stock returns resulting from recommendation upgrades. This finding suggests that investors perceive these recommendations as more reliable since the adoption of the new regulation. This effect is not at the cost of less credible downgrades, the introduction MAD having no impact on market reactions to recommendation downgrades. However, the introduction of MAD had no impact on financial institutions with investment banking business, the most exposed to conflicts of interest, mainly because these conflicts did not materialize, even before the new regulation was passed. Finally, we examine whether the US regulation devoted to investment research, which is very similar to the European one, spilled over into the European Union, making MAD useless. Our results show that the Market Abuse Directive has its own legitimacy since the US regulation did not affect returns of European stock resulting from recommendations potentially biased by conflicts of interest.

Keywords: Financial analysts, conflicts of interest, recommendations, Market Abuse Directive, European Union

JEL Classification: G18